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FNCE 30001 Investments 2. . (See your textbook Bodie, Kane and

Short Selling, Real Returns, and Mean-Variance Preferences Marcus, 2019, Section 5.3, pp. 122-124 for more on this). In Bodie, Kane and Marcus (2019)
they calculate the risk aversion coefficient (A) for a mean-variance optimizing investor as 2
Problem Set
(A=2). They assume that and the scenario variance is . Campbell
Due the week of 9 August 2021 Harvey and John Graham in a 2018 paper survey CFOs and other financial directors and
find that for the U.S. and that the scenario variance is .
Assignment is UNMARKED What is the risk aversion coefficient based for US investors, based on these survey data? Are
those described in
the textbook?

Normally, there will be a mixture of marked and unmarked questions to provide a few more topics to cover
during your tutorials. Please read the directions each week! It can affect your mark! Because this entire assignment
is unmarked this week, I am not distinguishing marked from unmarked as it all unmarked.

3 31 seems crazily high.

Feel free to check your work in Excel (in fact, I encourage it), but please do the questions by
hand. Why? It forces you to think more, and hopefully more about the economic intuition and
bject.
to better understand what you are doing.

1. This is related to the utility formula: . 3. Real and nominal return. Note that , where i is the rate of inflation.
Utility formula data The return experienced by Australian investors over 1992 to 2012 averaged 10.43% per year
Investment Expected Return, Standard deviation, and inflation was 2.66%. (See Bodie, et al. Section 5.4.)
1 .12 .3 a. should these averages be a geometric or arithmetic average?
2 .15 .5 Answer: Geometric.
3 .21 .16
4 .24 .21 b. What was the average real return from 1992 to 2012?
Answer:
a. Based on the formula for required risk premium above, which investment would you
select if you were risk averse with A=4?

Answer: It is clear that 3 and 4 dominate 1 and 2 because the expected returns are
That is a pretty amazing return.

Whether 3 or 4 is preferred is a little less clear (but I be

3:
4:

3 wins.

b. Which do you choose if you are risk neutral?

Investment 4, because the you are

risk neutral.

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4. Scenarios 1, 2 and 3 are equally likely. Consider two assets, A and B. A earns 4%, -5%, or 5. XYZ share price and dividend history are as follows:
3%, in scenarios 1, 2, and 3. B earns -5%, 3%, or 4%, in scenarios 1, 2, and 3. Year Beginning-of-year Price Dividend paid at end of year
a. Compute the expected rates of return and Std. Dev. for each asset, A and B. 2007 $100 $4
Answer: 2008 $110 $4
Expected Return for A = (4-5+3)/3 = 0.67%. 2009 $90 $4
Expected Return for B =(-5+3+4)/3 = 0.67%. 2010 $95 $4
Note that the Std. Deviation will also be the same for A and B, since they have identical An investor buys three shares of XYZ at the beginning of 2007, buys another two shares at
expected returns and possible returns in the 3 equally likely situations. the beginning of 2008, sells one share at the beginning of 2009 and sells all four remaining
shares at the beginning of 2010.
SD(asset A or asset B) =
a. What are the arithmetic and geometric average time-weighted rates of return for the
b. Now, consider a portfolio of assets A and B, where the investor holds a fraction of investor?
his portfolio in each asset: 40% in A and 60% in B. What is the Standard Deviation 6. Year Return = [(capital gains + dividend)/price]
of this new diversified AB portfolio? (110 100 + 4)/100 = 14.00%
(90 110 + 4)/110 = 14.55%

Now consider the new payoff table for each situation for Portfolio AB: (95 90 + 4)/90 = 10.00%
Situation 1: Arithmetic mean:
Situation 2:
Situation 3:

Consider the new Expected rate of return (which should hopefully be the same, since the
Geometric mean:
portfolio is composed of two assets with the same Expected Return!):
(3.6-.2-1.4)/3 = (2/3)% = (0.67)%, which is the same as before.

Now consider the AB risk:

b. What is the dollar-weighted rate of return? (Hint: Carefully prepare a chart of cash
flows for the four dates corresponding to the turns of the year for 1 January 2007 to
1 January 2010. If your calculator cannot calculate internal rate of return you will
The standard deviation of the portfolio of 2 imperfectly correlated assets is less. have to use a spreadsheet or trial and error.)
Time Cash flow Explanation
c. You will need to read section 5.2 again (pages 69-70) as this topic was not covered in
0 300 Purchase of three shares at $100 per share
invested $100,000 in portfolio AB?
1 208 Purchase of two shares at $110,
From formula 5.10 in the text, we get that the the 5% VaR for return is:
plus dividend income on three shares held

2 110 Dividends on five shares,

And -2.83% of $100,000 is -$2830. plus sale of one share at $90

So, the 5% VaR of this $100,000 investment for this time frame is $2830.
3 396 Dividends on four shares,

plus sale of four shares at $95 per share

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396 The value of the portfolio (X) must satisfy: X(1.20) = $100 000 X = $83 333
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| d. Comparing your answers to (a) and (c), what do you conclude about the
110 | relationship between the required risk premium on a portfolio and the price at
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which the portfolio will sell?
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Date: 1/1/ 0 7 1/1/ 08 1/1/ 09 1/1/ 10
For a given expected cash flow, portfolios that command greater risk premiums must sell at
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| | lower prices. The extra discount from expected value is a penalty for risk.
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| 208 7. You are pessimistic about Telecom shares and decide to sell short 100 shares at the current
300
market price of $50 per share.
a. How much in cash or securities must you put into your brokerage account if the
Dollar-weighted return = internal rate of return = 0.1661%

6. Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be Initial margin is 50% of $5000 or $2500
either $50 000 or $150 000, with equal probabilities of 0.5. The alternative riskless investment
in T-notes pays 5%. b. How high can the price of the stock go before you get a margin call if the
a. If you require a risk premium of 10%, how much will you be willing to pay for maintenance margin is 30% of the value of the short position?
the portfolio?
Total assets are $7500 ($5000 from the sale of the stock and $2500 put up for margin).

The expected cash flow is: (0.5 × $50 000) + (0.5 × $150 000) = $100 000 Liabilities are 100P. Therefore, net worth is ($7500 100P). A margin call will be issued

With a risk premium of 10% the required rate of return is 15%. Therefore, if the when:

value of the portfolio is X then in order to earn a 15% expected return: $7500 100 P
= 0.30, when P = $57.69 or higher.
100 P
X(1.15) = $100 000 X = $86 957

b. Suppose the portfolio can be purchased for the amount you found in (a). What c. Suppose the price drops to $45, ignoring transaction costs and lending fees, what
will the expected rate of return on the portfolio be? is your holding period return?

If the portfolio is purchased at $86 957, and and the expected payoff is $100 000, then Revenue from closing out the short sale at $45 is
$7500 (assets in the account) - $4500 to buy back the stock = $3000
the expected rate of return, E(r), is:
= 0.15 = 15.0% Cost: you were our of pocket $2500.
The portfolio price is set to equate the expected return with the required rate of return.

c. Now suppose you require a risk premium of 15%. What is the price you will be
willing to pay now?

If the risk premium over T-notes is now 15%, then the required return is:
5% + 15% = 20%

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